Changes in the federal funds rate will always affect the U.S. dollar. When the Federal Reserve increases the federal funds rate, it normally reduces inflationary pressure and works to appreciate the dollar.
Since June 2006, however, the Fed has maintained a federal funds rate of close to 0%. In the wake of the 2008 financial crisis, the federal funds rate fluctuated between 0-0.25%. Now, the target is 1.0% -1.25%, and it's expected to rise further.
The Fed used this monetary policy to help achieve maximum employment and stable prices. Now that the 2008 financial crisis has largely subsided, the Fed will look to increase interest rates to continue to achieve employment and to stabilize prices.
Inflation of the U.S. Dollar
The best way to achieve full employment and stable prices is to set the inflation rate of the dollar at 2%. In 2011, the Fed officially adopted a 2% annual increase in the price index for personal consumption expenditures as its target. When the economy is weak, inflation naturally falls; when the economy is strong, rising wages increase inflation. Keeping inflation at a growth rate of 2% helps the economy grow at a healthy rate.
Adjustments to the federal funds rate can also affect inflation in the United States. The Fed controls the economy by increasing interest rates when the economy is growing too fast. This encourages people to save more and spend less, reducing inflationary pressure. Conversely, when the economy is in a recession or growing too slowly, the Fed reduces interest rates to stimulate spending, which increases inflation.
During the 2008 financial crisis, the low federal funds rate should have increased inflation. Over this period, the federal funds rate was set near 0%, which encouraged spending and would normally increase inflation.
However, inflation is still well below the 2% target, which is contrary to the normal effects of low interest rates. The Fed cites one-off factors, such as falling oil prices and the strengthening dollar, as the reasons why inflation has remained low in a low interest environment.
The Fed believes that these factors will eventually fade and that inflation will increase above the target 2%. To prevent this eventual increase in inflation, hiking the federal funds rate reduces inflationary pressure and cause inflation of the dollar to remain around 2%.
Appreciation of the U.S. Dollar
Increases in the federal funds rate also result in a strengthening of the U.S. dollar. Other ways that the dollar can appreciate include increases in average wages and increases in overall consumption. However, although jobs are being created, wage rates are stagnant.
Without an increase in wage rates to go along with a strengthening job market, consumption won’t increase enough to sustain economic growth. Additionally, consumption remains subdued due to the fact that the labor force participation rate was close to its 35-year low in 2015. The Fed has kept interest rates low because a lower federal funds rate supports business expansions, which leads to more jobs and higher consumption. This has all worked to keep appreciation of the U.S. dollar low.
However, the U.S. is ahead of the other developed markets in terms of its economic recovery. Although the Fed raises rates cautiously, the U.S. could see higher interest rates before the other developed economies.
Overall, under normal economic conditions, increases in the federal funds rate reduce inflation and increase the appreciation of the U.S. dollar.